Credit risk is the risk that the issuer's credit rating will be downgraded, which could decrease the bond's value. Lower credit ratings also are an indicator that a bond may be subject to default risk, or the risk that the issuer will not be able to pay interest and/or principal. When investing in bonds, be sure to assess these risks.
Keep in mind that not all bonds are subject to credit or default risk. U.S. Treasury securities, because they are backed by the full faith and credit of the U.S. government, have no credit or default risk. Agency bonds, which are issued by government-sponsored entities, have a low level of credit and default risk. Municipal and corporate bonds, however, have varying levels of credit and default risk.
One way to assess a bond's credit or default risk is by reviewing its bond rating. Rating agencies assign ratings to bonds to give investors an indication of the bond's investment quality and relative risk of default. Major rating agencies include Moody's Investors Service, Standard & Poor's (S&P), and Fitch IBCA. Before assigning a rating, these services thoroughly review a bond issue.
The agencies assign letter ratings, with the first four categories considered investment-grade bonds and the lower categories are considered speculative. Not sure that credit ratings are useful in assessing credit risk? S&P calculated the average cumulate default rates 15 years from the initial bond rating by grade. The default rates were 0.67% for AAA, 1.3% for AA, 2.88% for A, 9.77% for BBB, 24.51% for BB and B, 41.09% for CCC, CC, and C, and 60.7% for D (Source: 2004).
After a bond is issued, the rating agencies continue to monitor it, changing the rating if warranted. The agencies also give advance warning of possible changes. Lowered ratings can mean a decline in market value of the downgraded debt for investors and higher future financial costs for the issuer. Price changes are typically minor if the rating changes by only one notch. However, certain downgrades are more significant and should cause you to review whether to continue holding the bond:
- A downgrade that moves a bond from an investment-grade rating to a speculative rating.
- A downgrade of more than one notch.
- A series of downgrades over a short time period.
A rating is a general guide of a bond's investment quality and risk of default, not a recommendation to purchase the bond. Other factors should be considered before investing in a particular bond.